Persistently buoyant equity markets have confounded some investors who expected the political turmoil in Washington, falling oil prices, and increasingly hawkish central banks around the world to take a greater toll on securities prices. What may have been forgotten, however, is the tremendous resiliency and adaptability of developed-world economies in this new era of ubiquitous innovation. Moreover, corporate earnings are ultimately the driver of stock prices and those have been coming in strong.

Over the first half of 2017 securities prices have been on the upswing. Year-to-date, the S&P 500 has advanced in price by 8.2 per cent, the MSCI World Stock Index gained 9.4 per cent and Emerging Markets returned 17.2 per cent. Almost surprisingly, bond markets have also moved up despite three Federal Reserve rate hikes in the past six months just as QE is quite possibly coming to an end in Europe.

Normally, bond prices move in the opposite direction as interest rates, but this year other factors are at play. Specifically, the shape of the yield curve combined with narrower yield spreads between corporate and sovereign bond yields have kept a bid on fixed income prices. Tighter spreads have offset higher short-term interest rates while longer-term interest rates remained subdued as the yield curve flattened. For the first half of the year, the Barclays Aggregate Bond index advanced by 2.3 per cent, despite a modest correction near the end of the second quarter — I think a decent result in light of the still ultra-low global interest rate environment.

Underpinning both the move up in equity prices and tighter credit spreads has been a consistent improvement in aggregate corporate profits. Companies in Europe, North America and Asia have been reporting earnings this year which have exceeded expectations.

In the US, two-thirds of the corporations beat expectations in the first quarter, but the strongest results actually came from Asia, followed by Europe. Relatively better earnings combined with cheaper valuations have helped non-US markets to begin outperforming the American averages this year, an outcome I had predicted earlier in this column (“The case for global equities”, April 21, 2017).

First-quarter 2017 earnings growth in the US were reported at a respectable 12.5 per cent year-over-year growth rate, making it the highest increase since the third quarter of 2011 and the first time we have seen double-digits progress since the fourth quarter of 2011.

Right now, we are just beginning the second-quarter earnings reporting season but so far results are encouraging. The large US banks reported last week, with JPMorgan Chase and Citigroup exceeding expectations on both the top and bottom lines despite a challenging trading environment.

According to FactSet research, second-quarter earnings growth for the S&P 500 is expected to come in around 6.5 per cent. Sectors likely contributing to ongoing profit gains include technology, energy and financial services. While the consistently strong performance of technology industry bell weathers including Apple, Oracle, Microsoft and Alphabet (formerly Google) is well known, financial companies including banks are also poised for progress.

The S&P 500 Financials sector was likely helped a few weeks ago when the Federal Reserve Board increased the target range for the federal funds rate by another quarter point.

Earnings for banks and other companies in the financial sector generally benefit from higher rates in this environment as floating-rate loans are repriced at higher rates while tight-fisted banks remain reluctant to offer any more interest to their depositors.

Since mid-June we have begun to witness a rotation from higher-priced growth stocks towards more “value-type” sectors including financials and I think this can continue. In fact, several favourable tail winds appear to be coming together for banks in particular: stronger capital positions, bigger dividends, steeper global yield curves and a more favourable regulatory environment.

Under the gun from regulators, banks in both the US and Europe have recapitalised massively since the Great Recession and finally they have some flexibility. All the US banks, for example, passed their stress tests with flying colours last month and are now allowed to begin returning more capital back to shareholders.

Large bank dividend increases have already been announced. Citigroup just doubled their dividend while JPMorgan increased theirs by 12 per cent. Higher dividends means more banks will now be included in the large and growing dividend-focused exchange-traded funds.

On the regulatory front, things are also improving. As opposed to the ongoing US political struggle with healthcare reform, financial deregulation has had some early successes but without much fanfare. Adding to the bull case, global yield curves are rising as investors see the beginning of the end of QE and unwinding of the Fed’s balance sheet. This is a positive for the financial sector’s net interest margins, which contribute to bank profitability.

Looking ahead, expect markets to continue to trade off reported profits and future earnings guidance. Although we are in a seasonally weak period for the risk markets, longer-term investors may be rewarded by buying on dips and rebalancing towards out-of-favour sectors.

This is a good time to stay diversified in the face of heightened political and fiscal uncertainty. Maintaining a balance between stocks/bonds, US/global and growth/value will be the key to preserving capital and growing it over time.

Bryan Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority

Markets showing their resilience

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